Saturday, November 27, 2010

The Instability of Economics

In my previous post, I mentioned how political rhetoric is often divorced from reality using an article by an economist to illustrate. But as this excellent post by Paul Krugman illustrates, economics itself can be divorced from reality, especially due to the tendency by economists to assume away critical aspects of reality.

As Paul Krugman notes and under a system that he prefers, microeconomics and macroeconomics proceed using very different approaches. Basically, microeconomics starts from the false assumption that people are rational and is very much grounded in the idea that exchange is beneficial despite the evident self-interest of the bread maker who provides you with bread. Microeconomics is very much an academic discipline that takes Adam Smith's "invisible hand" as a mostly unquestioned starting point. In sharp contrast, macroeconomics traditionally has not had the luxury of assuming that people are collectively rational; one cannot explain an erratic business cycle, especially as exemplified by the Great Depression, in purely rational terms. For this reason, discussions of macroeconomics often proceed with discussions of ideas, like "confidence," that are not only difficult to quantify and but where the origins of the problem itself are difficult to ascertain. That is, even if you agree that the problem is one of "confidence," one's political biases are often likely to lead one to gravitate towards certain narratives concerning how problems of confidence arise. For example, the story that conservatives gravitate towards is that the problem is "uncertainty" concerning current political policy. According to the conservative narrative, apparently, we did not have to worry about the "uncertainty" caused by wars in Afghanistan and Iraq, regulatory failure to stop a housing bubble, and the second Bush administration's transformation of large surpluses inherited from the Clinton administration into staggering deficits, but we apparently have to worry deeply about moderate reforms to the health care system and regulation intended to make a financial crisis like the one we have recently experienced less likely. While I prefer the simpler narrative that the "confidence" problems are more related to the concerns of businesses and that sufficient buyers for their products will fail to materialize due to a poor economy and the concerns of consumers that their job may not be as secure as they thought, the claim that problems of confidence are actually caused by political policy is not one that is cleanly disprovable. It is, like claims that there must be sacrifices to the gods lest we incur their wrath, more a matter of religion than science. One can understand then how economists, with their desire to make economics "more scientific" would gravitate towards simplifying assumptions that (however unrealistic) make economics feel as though it is on a firmer foundation than it really is. If we assume that people are just "rational" (whatever that means), then we do not have to have psychological discussions concerning such slippery concepts such as "confidence." In a word, the understandable desire for more certainty and a firmer foundation is probably the strongest motivator for the movement to establish micro foundations for macroeconomics.

The psychological desire of economists to grasp onto the illusion of greater certainty, even the perhaps hubristic desire to transform economics into a "real science" may be quite understandable. But what economists need to ask themselves is not just what is desirable, but what is possible. Since people are not in fact "rational" but instead subject to systematic biases, is assuming they are a good starting point for microeconomics, much less macroeconomics? The downsides are evident, especially when economists not only fail to produce recommendations tending towards good policy, but are also behind recommendations leading to bad policy, as in the urge to deregulate the financial sector or the advice of certain economists to ignore the housing bubble or even deny that there was such a bubble. (And isn't saying that high prices constitute a "bubble" just another one of those slippery concepts, like "confidence," that a mindset that gravitates towards certainty might have difficult tackling?)

I ultimately think that Paul Krugman is right. A policy divide where microeconomics and macroeconomics are sharply divided in their methodology is ultimately probably an unstable one. While Krugman finds such a divide to be ideal, I disagree. I have never thought it was healthy for analysis in microeconomics to proceed in a manner dependent on the assumption of a rigidly defined rationality. However, instead of finding micro foundations for macroeconomics, I think the direction will be to find, as it were, macro foundations in microeconomics. This is best illustrated by the rise of behavioral economics, a rising field dedicated to putting microeconomics on more realistic and secure psychological foundations, but in the process of doing so, perhaps robbing economists of a false sense of security and certainty.

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